Direct Write-off Method of Accounting for Bad Debts

On March 31, 2017, Corporate Finance Institute reported net credit sales of $1,000,000. Using the percentage of sales method, they estimated that 1% of their credit sales would be uncollectible. As mentioned earlier in our article, the amount of receivables that is uncollectible is usually estimated. This is because it is hard, almost impossible, to estimate a specific value of bad debt expense. Sometimes people encounter hardships and are unable to meet their payment obligations, in which case they default. Therefore, there is no guaranteed way to find a specific value of bad debt expense, which is why we estimate it within reasonable parameters.

We use this estimate to record Bad Debt Expense and to setup a reserve account called Allowance for Doubtful Accounts (also called Allowance for Uncollectible Accounts) based on previous experience with past due accounts. We can calculate this estimates based on Sales (income statement approach) for the year or based on Accounts Receivable balance at the time of the estimate (balance sheet approach). However, the direct write-off method can result in misstating the income between reporting periods if the bad debt journal entry occurred in a different period from the sales entry. For such a reason, it is only permitted when writing off immaterial amounts. The journal entry for the direct write-off method is a debit to bad debt expense and a credit to accounts receivable.

• Because customers do not always keep their promises to pay, companies must provide for these uncollectible accounts in their records.
• How long is appropriate for a company to leave past due A/R on the books before writing it off?
• Similar to its name, the allowance for doubtful accounts reports a prediction of receivables that are “doubtful” to be paid.
• The direct write-off method can be a useful option for small businesses infrequently dealing with bad debt or if the uncollectibles are for a small amount.

If you’re a small business owner who doesn’t regularly deal with bad debt, the direct write-off method might be simpler. But the allowance method is more commonly preferred and often used by larger companies and businesses frequently handling receivables. If you’re wondering which method is best for your small business, speak with a professional for insights into your specific situation. The direct write-off method doesn’t adhere to the expense matching principle—an expense must be recognized during the same period that the revenue is brought in.

Direct write off method definition

It is important for management to monitor the balance to ensure the balance is reasonable. We must create a holding account to hold the allowance so that when a customer is deemed uncollectible, we can use up part of that allowance to reduce accounts receivable. Allowance for Doubtful Accounts is a contra-asset linked to Accounts Receivable.

• But the allowance method is more commonly preferred and often used by larger companies and businesses frequently handling receivables.
• Remember that allowance for doubtful accounts is the holding account in which we placed the amount we estimated would go bad.
• We must create a holding account to hold the allowance so that when a customer is deemed uncollectible, we can use up part of that allowance to reduce accounts receivable.

Under the direct write-off method, bad debt expense serves as a direct loss from uncollectibles, which ultimately goes against revenues, lowering your net income. For example, in one accounting period, a company can experience large increases in their receivables account. Then, in the next accounting period, a xero partner program lot of their customers could default on their payments (not pay them), thus making the company experience a decline in its net income. Therefore, the direct write-off method can only be appropriate for small immaterial amounts. We will demonstrate how to record the journal entries of bad debt using MS Excel.

Since the unadjusted balance is $9,000, we need to record bad debt of $5,360. As with every other entry we have completed, the first step is to identify the accounts. This is another variation of  an allowance method so we will use Bad Debt Expense and Allowance for Doubtful Accounts.

The Direct Write off Method vs. the Allowance Method

Bad Debt Expense increases (debit), and Allowance for Doubtful Accounts increases (credit) for $48,727.50 ($324,850 × 15%). Let’s consider that BWW had a $23,000 credit balance from the previous period. For example, a customer takes out a $15,000 car loan on August 1, 2018 and is expected to pay the amount in full before December 1, 2018. For the sake of this example, assume that there was no interest charged to the buyer because of the short-term nature or life of the loan. When the account defaults for nonpayment on December 1, the company would record the following journal entry to recognize bad debt. The direct write-off method is a way for businesses to record bad debt.

The allowance for doubtful accounts is a contra asset account and is subtracted from Accounts Receivable to determine the Net Realizable Value of the Accounts Receivable account on the balance sheet. In the case of the allowance for doubtful accounts, it is a contra account that is used to reduce the Controlling account, Accounts Receivable. When using the percentage of receivables method, it is usually helpful to use T-accounts to calculate the amount of bad debt that must be recorded in order to update the balance in Allowance for Doubtful Accounts. This is very similar to the adjusting entries involving shop supplies or prepaid expenses.

If the company applies the balance against the customer’s account, the entry would cause a negative balance or an amount due to the customer. In order to accept the payment, the company must first restore the balance to the customer’s account. It’s not revenue because the company has not done any work or sold anything.

The entry from December 31 would be added to that balance, making the adjusted balance $60,500. The percentage of sales method does not factor in the existing balance in Allowance for Doubtful Accounts. Without careful monitoring, the balance in the account could grow indefinitely.

What is the Direct Write Off Method?

It seems counterintuitive to restore the balance to pay it off, but for recordkeeping purposes, it is necessary to restore the account balance and show the customer properly paid his debt. We must make sure to show that Joe Smith paid the amount he owed, not just the fact that the company received some cash. Under the direct write off method, when a small business determines an invoice is uncollectible they can debit the Bad Debts Expense account and credit Accounts Receivable immediately. This eliminates the revenue recorded as well as the outstanding balance owed to the business in the books. Under the allowance method, a company needs to review their accounts receivable (unpaid invoices) and estimate what amount they won’t be able to collect. This estimated amount is then debited from the account Bad Debts Expense and credited to a contra account called Allowance for Doubtful Accounts, according to the Houston Chronicle.

Direct write off method disadvantages

For example if sales are made at the end of accounting year 20X1, bad debts will be realized in the beginning months of accounting year 20X2. Thus the use of direct write-off method would cause deduction of expenses of previous period against revenue of current period which is contrary to the matching principle of accounting. Therefore, it not advised to use direct write-off method other than for very small businesses. Companies turn to the allowance method to properly report revenues and the related expenses in the periods that they were earned and incurred. The allowance shows up as a contra-asset to offset receivables on the balance sheet and as bad debt expense to offset sales on the income statement.

Auditors use several techniques to assess whether the allowance for doubtful accounts appears reasonable. Management can use similar techniques to self-audit the company’s allowance. Some companies also include allowances for returns, unearned discounts and finance charges. Given the current economic stress, your business might have to update its historical strategies for assessing the collectability of its receivables.

Accounts Receivable as a Target for Fraud

It’s also important to note that unpaid invoices are categorized as assets, which are debited in accounting. Reporting a bad debt expense will increase the total expenses and decrease net income. Therefore, the amount of bad debt expenses a company reports will ultimately change how much taxes they pay during a given fiscal period.

What is the Direct Write-off Method for Bad Debts?

Assuming that credit is not a significant component of its sales, these sellers can also use the direct write-off method. The companies that qualify for this exemption, however, are typically small and not major participants in the credit market. Thus, virtually all of the remaining bad debt expense material discussed here will be based on an allowance method that uses accrual accounting, the matching principle, and the revenue recognition rules under GAAP. The specific action used to write off an account receivable under this method with accounting software is to create a credit memo for the customer in question, which offsets the amount of the bad debt. Creating the credit memo creates a debit to a bad debt expense account and a credit to the accounts receivable account. Allowance for Doubtful Accounts is a holding account for potential bad debt.